Introduction to Finance

18.1
Why Choose a Capital Structure?
A fi rm’s mix of debt and equity used to fi nance its assets defi nes the fi rm’s 
capital structure
 
as seen in 
Figure 18.1
. In this chapter, we will fi rst review the importance of a fi rm’s capital 
structure
 
and how the capital structure and the costs of each fi nancing source can be combined 
to provide
 
an estimate of the WACC. We’ll examine the interrelationship
 
among a fi rm’s 
growth rate, dividend policy, and capital structure decisions. Then we’ll
 
review the infl uences 
that aff ect a fi rm’s choice of a capital structure over time.
Obviously, a target capital structure is important as it determines the proportion of debt 
and equity used to estimate a fi rm’s cost of capital. There is, however, a second, more 
important reason. The fi rm’s 
optimum debt/equity mix
minimizes the fi rm’s 
cost of capital
, 
which, in turn helps, the fi rm to maximize shareholder wealth.
For example, suppose a fi rm expects cash fl ows of $20 million annually in perpetuity. 
Each of the three capital structures shown in 
Table 18.1
has a diff erent weighted average cost 
capital structure 
fi rm’s mix of 
debt and equity used to fi nance a 
fi rm’s assets
optimum debt/equity mix 
proportionate use of debt and 
equity that minimizes the fi rm’s 
cost of capital
cost of capital 
minimum acceptable 
rate of return to a fi rm on a project

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18.1 Why Choose a Capital Structure?
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of capital. Following the perpetuity valuation rule from Chapter 9, fi rm value is computed 
by dividing the expected cash fl ow by the fi rm’s cost of capital under each capital structure. 
Capital Structure 2 in the following table minimizes the cost of capital at 8 percent, which, in 
turn, maximizes the value of the fi rm at $250 million.
A nonoptimal capital structure with too much or little debt leads to higher fi nancing costs, 
and the fi rm will likely reject some capital budgeting projects that could have increased share-
holder wealth with an optimal fi nancing mix. For example, suppose a fi rm has a minimum cost 
of capital of 8 percent, but poor analysis leads management to choose a capital structure that 
results in a 10 percent cost of capital. It would then reject an average risk project that costs 
$100,000 and returns cash fl ows of $26,000 in years one through fi ve at a 10 percent cost of 
capital (NPV = –$1,434). This project would be acceptable at the minimum possible cost of 
capital of 8 percent (NPV = $3,818).
There is another, more intuitive way to see the importance of fi nding the optimal capital 
structure. A project’s NPV represents the increase in shareholders’ wealth from undertaking a 
project. From Chapter 10, we know there is an inverse relationship between value and discount 
rates (the “seesaw eff ect”). Thus, a lower weighted average cost of capital gives higher project 
NPVs, and results in higher levels of shareholder wealth.
Trends in Corporate Use of Debt
The ratio of long-term debt to gross domestic product (GDP) for U.S corporations grew during 
the 1960s until, as seen in